However moods play a much more important role once

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Unformatted text preview: n and Winston (2002), and Song and Thakor (2008). 58 This was certainly not a minor achievement—it involved standardizing the credit risk screening (through scoring and rating), breaking it up (through stripping and tranching) and dispersing it (by selling it to a wider base of investors and spreading it around through a new breed of credit risk derivatives). 59 Information got lost through the “chain of complexity” and banks became exposed in the process to heavy “pipeline risk”. See Brunnermeier (2008) and Gorton (2008). 60 See Gorton (2008)and Coval, Jurek, and Stafford (2008). 61 See Calomiris (2008). 62 See Taleb (2007). 63 Unlike commercial banks that targeted a constant leverage throughout the cycle, investment banks’ leverage was heavily pro‐cyclical. See Adrian and Shin (2007 and 2008). 37 only had the immediate mechanical effect of reducing values at risk but also, the more it persisted, the more it fed the feeling that “this time around, things are different and the good times are here to stay”. New forms of macro‐financial management and oversight, including the ever more sophisticated risk modeling, widespread divestment of risk through risk derivatives, and more effective and successful monetary management, were all major contributors to this optimistic picture.64 Feelings such as “everything is being taken care of”, “good men are now in charge”, and “systemic volatility is a memory of the past which has now been vanquished even by the Mexicos and Brazils of this world” became so prevalent that few really questioned them. On the way down, the brutal downward swing in the prevalent market mood also fed the collapse. A significant dissonance would be enough to initiate the mood swing. In the Subprime crisis, the swing was arguably triggered when the CBX credit swap index on sub‐prime based instruments started going south, colliding with the still rosy assessments of the rating agencies.65 As long as there was widespread market agreement on a price vector, ensuring that instruments could continue to be unloaded on short notice, markets could go on functioning unperturbed (whether prices actually matched fundamentals was not that important as long as they were uncontested). However, by questioning the uniformity of market assessments, the drop in the CBX index suddenly raised the specter of “hidden icebergs lying ahead”. From euphoria, the mood shifted into acute Knightian uncertainty, where risk aversion swelled, driven by the fear of the unknown.66 The frenzied recoiling of investors was compounded by general market opacity—including the knowledge that intermediaries were deeply interconnected coupled with utter ignorance on the nature and specific details of this interconnectedness. Opacity thus intensified the massive sell out of securities and simultaneous flight to cash, with the resulting market collapse and evaporation of price signals further accentuating the downward spiral.67 In this paradigm, well‐meaning public policy also played a central role, both on the way up and on the way down. On the way up, a key and justifiable role for poli...
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